The worst first half of the market in 50 years is all about one thing

Traders on the floor of the NYSE, June 13, 2022.

Source: NYSE

A host of factors conspired to generate the stock market’s worst first half since 1970, but they all stemmed from one word: inflation.

The cost of living started the year at levels the US hadn’t seen since the early 1980s.

Worse, Federal Reserve officials armed with full-year forecasts of “passing” inflation that now seem almost comically inaccurate, fell behind, endangering a market and economy still fragile from the Covid pandemic.

Six months later, the damage was severe, but not catastrophic: an S&P 500 drop of nearly 20%, a symbol of how risk investing across the spectrum, from crypto to IPOs and even some parts of the commodities market, has collapsed.

“It was inflation. That’s the Fed’s nemesis,” said Quincy Krosby, chief equity strategist at LPL Financial. “It was the Fed that stuck to its ‘transient’ mindset of inflation easing. … It was central bank generosity, it was government generosity. The Fed was surprised [about inflation] even just a few days before the last meeting. That’s how we got here.”

Supply chain constraints that the Fed thought would ease were responsible for much of the rise in inflation. Demand has simply overwhelmed shippers’ ability to get products to market, resulting in much higher prices. The Russian attack on Ukraine has exacerbated some of those problems, pushing up energy and food prices. Consumer confidence has contracted and inflation expectations, among consumers, if not the financial markets, have risen sharply.

Missed signals, massive damage

After falling behind the inflation curve, the Fed is now forced to catch up with rate hikes worth 1.5 percentage points, with more to come. Many on Wall Street have wondered why the Fed hasn’t been even more aggressive.

Uncertainty about the path ahead has exacerbated the thorny impact of inflation with one Labor Department measure to 8.6%, the highest since December 1981. As late as December 2021, the Fed, which is projecting inflation of 2%, turn its preferred general measure at 2.6% this year; new data Thursday showed it at 6.3%, with core inflation excluding food and energy as high as 4.7%.

Fed Chair Jerome Powell “needs to regain control of the inflation narrative…now he’s losing total control,” Mohamed El-Erian, Allianz’s economic adviser, recently told CNBC. “He has to move because if he doesn’t, he’s going to chase the market and he won’t get there.”

In addition to the damage done to major stock market averages such as the S&P 500 and the Dow Jones Industrial Average, which have fallen more than 14% so far, there has been carnage everywhere.

The Nasdaq, which has a stronger focus on technology, has suffered losses of almost 30%. Bitcoin, the most notable cryptocurrency, is down nearly 60%. Copper, often considered an economic factor, has fallen by more than 15% and cotton by more than 13%.

The capital markets have also taken a beating.

Special-purpose acquisition companies, which issue blank checks from investors and were all the rage last year, are struggling. CNBC’s Post SPAC Index, which tracks vehicles from their first listing through a merger target or live deal, is having its worst month since its launch in November 2020, dropping nearly 25%.

Private companies were slow to enter such a bleak market. According to Ernst & Young, the volume of IPOs fell 46% in the first half, while revenues fell 58% compared to the same period a year ago.

History offers hope

So what will stop the bleeding?

“For the market, the old saying is that the market gets the news first. All the market is waiting for is the Fed’s rhetoric to weaken,” LPL’s Krosby said. “That would move the market towards maybe a pause or maybe even” [interest rate increases of] 50 basis points or 25 basis points, depending on where we are.”

However, the markets expect another 75 basis point rate hike in July, the same as the one in June. A basis point is one-hundredth of 1 percentage point.

The only things that have worked this year have been certain areas of the commodity markets, such as oil, natural gas and some agricultural products. However, those gains were offset by huge losses in everything from banks to automakers to construction products.

Still, there is reason for optimism.

When the S&P 500 plunged 21% in the first half of 1970, it immediately reversed those losses to gain 26.5% in the second half and make a profit for the year.

“You trade and invest in the markets you have, not the markets you want,” Krosby said. “Can this market recover in the second half? A lot has to be lined up. But it has happened before.”

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